Educational Articles

Stock Screen: Bargain Basement Stocks - March 19, 2014

Sigourney B. Romaine, CFA
| March 19, 2014

The investing world is often broken down into two broad camps: growth and value. The growth group looks for companies with earnings that are advancing at a material clip. The value camp, meanwhile, looks for stocks that are trading on the cheap. The desire to find undervalued stocks is both emotionally and intellectually appealing—after all, who doesn’t like to take advantage of a sale? Moreover, value investing follows one of the oldest, and most obvious, sayings on Wall Street, “buy low, sell high.”

The problem is that everyone is trying to buy low and sell high, even the growth investors. So it’s important to properly define “cheap” and have a systematic way of identifying candidates that meet that criterion. Equally paramount is remembering that some merchandise winds up on the sale heap because it is damaged in some way. A fact that is as true for stocks as it is for consumer goods.

To help investors cull through the list of potential investments, Value Line provides weekly screens. One of the more useful screens for value investors is the Bargain Basement Stocks screen. The screen is fairly simple, highlighting companies with price-to-earnings multiples and price to “net” working capital ratios near the bottom of the Value Line universe. The idea is to identify companies that are trading cheaply relative to earnings and to the money that would be “left over” if the company were to be liquidated. Note, that most stocks never trade below their liquidation value, but even trading at two or three times that value is noteworthy.

This screen is available every week in the Index section of The Value Line Investment Survey. Subscribers can access the most recent Index here to see all 35 names on the list. Recent names that may interest bargain hunters, though for quite different reasons, include PulteGroup, Inc. (PHM) and Fuel Tech, Inc. (FTEK).

PulteGroup, Inc.

PulteGroup (formerly Pulte Homes) is one of the largest home builders in the United States. Through three brands, Pulte Homes, Del Webb, and Centex, it offers a wide variety of home designs, including single-family, row houses, condominiums, and duplexes at different prices and with varying options and amenities. The Pulte brand is directed toward the “move-up’’ market, while Del Webb targets “active adults’’ and Centex the entry-level market. At December 31, 2013, the company operated in 48 markets in 27 states, including the 11 biggest. In 2013, it closed sales of 17,766 homes, up 7.6% from the prior year, with 46% by the Pulte brand, 29% from Del Webb, and 25% from Centex.

In 2013, sales of single-family detached houses accounted for 85% of Pulte’s unit volume, and prices ranged from under $100,000 to over $1.2 million, with 86% in the $100,000 to $450,000 range. At December 31, 2013, Pulte was developing 577 housing communities. PulteGroup also offers title search and mortgage origination services, performing these activities for around 80% of its home buyers.

Like its entire industry, Pulte is recovering from the shock of the Great Recession, which saw industry unit volume plummet by around 75% from 2005 to 2009. In 2012, new home sales rose for the first time since 2005, and the trend continued last year, when new unit sales were up 16% from 2012, to 428,000. As the economy has continued to expand, if at a slower pace than we’d like, Pulte and its industry realized price increases last year. Pulte’s unit volume slowed a bit in the fourth quarter, but price increases, achieved thanks to the low industry new-home inventory, more than overcame the lower volume. At the 2014 forecast tax rate of 39% and before unusual items, December-period earnings were about $0.37 a share, up from $0.20 in the 2013 time frame. For 2013, on the same basis, Pulte earned around $0.95, compared with $0.40 in 2012. Moreover, thanks to the better times, the company reversed large deferred tax asset writedowns that it took in the recession, which improved its total debt-to-capital ratio to 31%, from 53% at the end of 2012.

Prospects look good for 2014, owing to the steadily gaining economy and job growth, low interest rates, and low new-home inventories. Indeed, in anticipation of better times to come, Pulte plans to invest around $2.0 billion in land acquisition and development this year, up from $1.3 billion in 2013. Margins, too, should widen as the company sells a good many more houses built on common floor plans; 21% of last year’s unit sales were built using these less-expensive models, and the goal is 40% this year, on its way to an ultimate hope of 70%. With a broad product line offering a home for most pocket books and $1.6 billion of cash as of December 31st, PulteGroup should get its share and perhaps a bit more of the present upswing in the housing market. And we expect the dividend to grow, too. In terms of the bargain basement screen, PHM’s price to net working capital and price to book ratios have improved a bit since the September 30th balance sheet, though its price to earnings ratio has worsened, owing to a higher forecast tax rate in 2014.

Fuel Tech., Inc.

Fuel Tech is a technology-based company that offers products and services for air pollution control, process optimization, and combustion efficiency. Both segments rely on technologies that inject chemical slurries into combustion units in precise concentrations and locations to achieve a desired outcome. Air pollution control (APC) offerings include low nitrogen oxide burners, post-combustion nitrogen controls, catalytic and non-catalytic reduction systems, among others. It has installed NOx reductions systems on over 800 units that use a wide variety of fuels, including coal, fuel oil, natural gas, and biomass, in about 30 countries.

In 2013, Fuel Tech’s sales and earnings increased 12% and 64%, respectively, thanks to success in China/Pacific Rim and in Chile. U.S. revenues slipped 11%, due to continuing uncertainty about the timing of new pollution control rules. In the fourth quarter, though, earnings came in well below our forecast, owing to lower sales as a large APC contract in Chile began to wind down, as well as higher general costs. In 2014, the large APC contract in Chile, the biggest in Fuel Tech’s history, is set to be completed by midyear. And APC installations in the United States will probably lag, as well. That said, business should continue to grow in China, where the company has had a presence since 2007 and is well known. All told, Fuel Tech expects the second half to be better than the first.

Fuel Tech main appeal is likely its China/Pacific rim business. China is increasing its pollution control efforts, and much more will be needed if that huge country is not to suffer declining food production and other unpleasant consequences of rapid construction of coal-fired power plants, which will certainly continue for a while. In the United States, the Supreme Court is to rule on the EPA’s Cross States Air Pollution Rule by this summer; if the rule is overturned, the EPA will very likely propose something as strict to replace it. Fuel Tech has some bigger, better known competitors, such as General Electric (GE -Free General Electric Stock Report), Babcock & Wilcox (BWC), and Foster Wheeler (FWLT), but its APC products cut pollution at a considerably lower cost per unit of capacity, such as megawatts. With respect to the bargain basement scale, Fuel Tech has improved since the September balance sheet on the price to net working capital metric and held steady on the price to book value ratio; its price to earnings ratio, though, has risen as a results of the disappointing fourth quarter results. Longer term, the company should benefit from tighter air pollution standards, and its nearly debt-free balance sheet makes acquisitions possible.

At the time of this article’s writing, the author did not hold positions in any of the companies mentioned.